ProfessorBainbridge.com

Exporting veil piercing's a very bad idea

I just finished reading an interesting article by Alexandra Horvathova and Catalin Gabriel Stanescu, Piercing the Corporate Veil: US Lessons for Romania & Slovakia, in which they argue that Romania and Slovakia ought to adopt an adapted version of the US doctrine of corporate veilo piercing. 

As someone who'd like to see the US abolish the veil piercing doctrine, I fail to understand why any rational country would chose to inflict veil piercing on itself without someone holding a gun to its head. After all, this is a doctrine of which it has been said that, instead of reasoned analysis, courts typically fall back on vague labels such as “alter ego” or “lack of separation,” which has been variously characterized as analysis by epithet and reasoning by pejorative.[1]

If the point needs further elaboration, consider the absurd internal inconsistency in DeWitt Truck Brokers, Inc. v. W. Ray Fleming Fruit Co.[2] The opinion opens with the observation that courts pierce the veil “reluctantly” and “cautiously.” Two pages later, however, we learn that courts “have experienced ‘little difficulty’ and have shown no hesitancy” in piercing the veil of close corporations. Which is it? The answer matters a lot to transaction planners, but the court leaves uncertain whether veil piercing is supposed to be the norm or the exception. No wonder Judge Cardozo described veil piercing as an enigmatic doctrine caught “in the mists of metaphor.”[3]

All of this, obviously, is inconsistent with the goals of certainty and predictability. At the same time, however, it may be doubted whether veil piercing contributes much to any plausible conception of either efficiency or equity. Yes, limited liability allows shareholders to externalize certain risks. Yet, veil piercing cannot be shown to cause investors to internalize risks appropriately. To the contrary, veil piercing “seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.”[4]

In my article, Abolishing Veil Piercing, I therefore argue that:

The corporate law doctrine of limited liability has been much written about, but veil piercing as such has gotten far less academic scrutiny. This article addresses that lacuna, offering a doctrinal and economic analysis of veil piercing. It concludes that veil piercing cannot be justified and, accordingly, advocates abolishing the doctrine. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to effect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large. Veil piercing thus has costs, but no social pay-off. 

Veil piercing tries to do too much. Allocating liability within a corporate group controlled by a publicly held corporation involves far different policy considerations than does holding liable the individual shareholders of a closely held corporation. These tasks should be unbundled. Intra-corporate group liability issues should be dealt with as a species of enterprise liability, while the liability of individual shareholders is the proper subject of veil piercing law. 

So defined and delimited, the survival of veil piercing is difficult--if not impossible--to defend. A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading shareholders to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question--did the defendant-shareholder do anything for which he or she should be held directly liable. Did the shareholder commit fraud, which led a creditor to forego contractual protections? Did the shareholder use fraudulent transfers or insider preferences to siphon funds out of the corporation? 

---

[1] Phillip I. Blumberg, The Law of Corporate Groups: Procedural Law 8 (1983) (“metaphor or epithet”); Franklin A. Gevurtz, Piercing Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of Piercing the Corporate Veil, 76 Or. L. Rev. 853, 855 (1997) (“pejorative”).

[2] 540 F.2d 681 (4^th Cir. 1976).

[3] Berkey v. Third Ave. Ry. Co., 155 N.E. 58, 61 (N.Y. 1926).

[4] Frank H. Easterbrook and Daniel R. Fischel, Limited Liability and the Corporation, 52 U. Chi. L. Rev. 89 (1985).

Money market reform and taxes

Steven Davidoff is dismissive of money market mutual fund industry complaints that proposed reforms would "require complex accounting and tax record-keeping by investors." Speaking personally, given the minuscule returns money market funds are paying these days, I probably would stop using them and just leave my rainy day savings/cash flow management funds in my checking account rather than trying to deal with headaches come tax time of having a constantly fluctuating NAV. Who wants to deal with paying taxes on, say, 10 cents worth of capital gains because you sold 1000 shares at $1.00 and had a basis in those shares of $0.9999? And what if you want to use actual cost basis instead of average cost basis? Maybe it'd be worth doing if you're a billion dollar institution, but my guess is that a floating NAV would drive retail investors out of the money market industry.

The adverse tax and accounting consequences, as well as the capital market consequences of driving retail investors out of the commercial paper market, seem an awfully high price to pay because Congress is to fraking chicken to tell voters that it won't bail out mutual funds that go bust.

Update: I am currently invested in a California tax-exempt money market paying a whopping 0.02% average annual rate of return. That probably doesn't even cover the opportunity costs of transferring money to it from checking. How high a return would the fund have to pay to justify the costs (both real and opportunity) associated with a floating NAV? At least enough to pay for a TurboTax program!

I love the way it's now liberals calling the Supreme Court a "super legislature"

Constitutional law experts overwhelmingly think the Affordable Care Act is Constitutional...

...but a majority think the super-legislature will strike down some of it.

via leiterlawschool.typepad.com

Brian: Welcome to our world. Those of us on the right have been complaining about it since, I don't know, Earl Warren's day.

...but a majority think the super-legislature will strike down some of it.

Defending director primacy from the Arrowian Moment Critique

In a recent law review article (35 Seattle U. L. Rev. 1033), Matt Bodie compliments my director primacy theory for having "move[d] the ball significantly when it comes to our conceptions of the modern corporation" and for having "been influential in academic, practitioner, and judicial circles." He notes, however, that:

Bainbridge fails to flesh out his theory sufficiently to justify the near absolute control he provides to the board. He repeatedly relies on Arrow's contrast between consensus and authority to resolve any questions of power allocation in favor of stronger authority. This move--characterized by Brett McDonnell as Bainbridge's “Arrowian moment”--is the crux of his model. But as McDonnell points out, Arrow's description of the tradeoff between authority and accountability does not resolve all policy questions in favor of authority. Ultimately, Arrow's dichotomy--and by extension, the director primacy model--is “not able to tell us whether reform in favor of somewhat more accountability at the expense of some, but far from total, loss in authority is a good idea or not.”

I responded to the "Arrowian moment" critique in a paper entitled, simply enough, Director Primacy, which appears in Research Handbook on the Economics of Corporate Law. In it, I argue that:

Critics of the director primacy model sometimes suggest that it overstates the importance of authority. Brett McDonnell (2009, 143), for example, argues that “Bainbridge moves very, very quickly from recognizing the tension between authority and accountability to arguing that we should presume a legal structure that favors authority over accountability, unless there are strong arguments against that presumption.” Apropos the discussion in the preceding section, however, I contend that the utility of director primacy is confirmed by its ability to explain one of the truly striking things about U.S. corporation law; namely, the extent to which the balance between authority and accountability in fact leans towards the former. As we’ve seen, for example, a host of rules serve to limit the power of shareholders vis-à-vis directors. As we’ve also just seen, the business judgment rule is designed precisely “to protect and promote the full and free exercise of the managerial power granted to Delaware directors.”^[1]

In the closely related context of the procedural rules governing shareholder derivative litigation, the New York Court Appeals stated in Marx v. Akers that “By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate boards.... Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation’s affairs should be ‘exercised with restraint.’”^[2] The Marx court further noted the need to strike “a balance between preserving the discretion of directors to manage a corporation without undue interference, through the demand requirement, and permitting shareholders to bring claims on behalf of the corporation when it is evident that directors will wrongfully refuse to bring such claims,” which is precisely the balance between authority and accountability the director primacy model predicts.

We observe similar rules seemingly designed to protect the board’s authority in statutory provisions, such as those governing transactions in which the directors are personally interested, including management buyouts, which involve a significant conflict of interest and therefore tend to get close judicial scrutiny, but which receive judicial deference in appropriate cases. (Bainbridge 1993, 1074-81) The same is true for the similar problem of target board of director resistance to unsolicited takeover bids. (Bainbridge 2008b)

On the other hand, I have never claimed that the board should have unfettered authority. In some cases, accountability concerns become some pronounced as to trump the general need for deference to the board’s authority. Once again, I turn to Arrow (1974, 78):

To maintain the value of authority, it would appear that [accountability] must be intermittent. This could be periodic; it could take the form of “management by exception,” in which authority and its decisions are reviewed only when performance is sufficiently degraded from expectations ....

Given the significant virtues of discretion, however, I continue to believe that one must not lightly interfere with the board’s decision-making authority in the name of accountability.

McDonnell (2008, 143) contends that this argument proves too much when applied to real world problems, however:

The argument that Bainbridge borrows from Arrow only tells us that there is a trade-off between authority and accountability, and that both have real value. It also tells us that it will generally be unwise to choose a structure that eliminates authority completely in favor of accountability, or vice versa. None of the major pro-accountability reform proposals currently in play, however, comes even close to eliminating board authority. In the world in which we live today, Arrow's argument is not able to tell us whether reform in favor of somewhat more accountability at the expense of some, but far from a total, loss in authority is a good idea or not.

... I have never denied that the argument McDonnell (2009, 143) calls my “Arrowian moment” doesn't do much more than establish a general presumption in favor of respecting director authority.[3] Each doctrinal problem must be carefully analyzed to determine where to strike the balance between authority and accountability. The necessary analysis typically requires one to go beyond the “Arrowian moment” to consider other policies. Hence, for example, my analysis of the business judgment rule acknowledged that:

Critics of the [Arrowian moment] likely would concede that judicial review shifts some power to decide to judges, but contend that that observation is normatively insufficient. To be sure, they might posit, centralized decision making is an essential feature of the corporation. Judicial review could serve as a redundant control on board decision making, however, without displacing the board as the primary decision maker. (Bainbridge 2008, 114)

To explain why the presumption in favor of authority prevails in this context, accordingly, I moved on to consider other policies, such as encouraging risk taking, preventing hindsight bias, and so on.

Similarly, I acknowledge that it’s not enough to point out that proposals to change the shareholder voting process would shift the balance towards accountability. One must go on to ask why such a shift is undesirable (or, preferably, to defend the presumption against such a shift). Hence, in Bainbridge (2008, chap. 5), for example, I went on to consider such questions as whether the shareholders would use the powers activists propose to give them, whether certain shareholders are more likely to do so than others, and whether those shareholders are likely to use their new powers to pursue private gains at the expense of other shareholders.

In sum, director primacy sets the stage. It defines the parameters within which the debate over particular issues takes place. It enables one to make broad predictions about the law and foundational critiques of legal rules that depart from those predictions. The fact that specific problems sometimes require additional fine tuning is hardly proof that the basic model is flawed.

Having made that concession, however, I must immediately recall, by way of analogy, recall Benjamin Cardozo’s famous dictum that the legal duties of a fiduciary should not be undermined by “the ‘disintegrating erosion’ of particular exceptions.”[4] Just so, if one believes that authority has survival value, one should protect the board of directors’ decision-making authority from the “disintegrating erosion” of reform.

This does not mean that one should always reject reforms that shift the balance towards accountability. It does, however, suggest one must pay attention to the cumulative impact of repeated reform proposals, lest one subject the board’s authority to the legal equivalent of death by a thousand cuts. It also suggests that there ought to be at least a presumption in favor of authority. In light of the huge advantages authority offers the corporate form, the burden of rebutting that presumption should be on those who wish to constrain the board’s authority.

---

[1] Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985).

[2] Mark v. Akers, 666 N.E.2d 1034, 1037 (N.Y. 1996) (quoting Gordon v. Elliman, 119 N.E.2d 331, 335 (N.Y. 1954)); see also Pogostin v. Rice, 480 A.2d 619, 624 (Del. 1984) (“[T]he derivative action impinges on the managerial freedom of directors ....”).

[3] As we have just seen, however, such a presumption has considerable explanatory value when one reviews the many corporate law doctrines that enshrine deference to boards. If one grants my starting hypothesis that corporate law tends towards efficient solutions, those doctrines are persuasive evidence for director primacy.

[4] Meinhard v. Salmon, 249 N.Y. 458, (N.Y. 1928).

UCLA Faculty Association: The U-VA Story Ain't Over

The University of Virginia library staff is archiving materials related to the recent events that forced Teresa A. Sullivan to resign as president of the institution.  This is the first time the libraries have tried to preserve materials from a large-scale, continuing event, said Bradley Daigle, director of digital-curation services. The staff did not begin collecting materials on the subject until a rally on June 18. As of June 22, the team has archived nearly 20,000 tweets, 61 blog posts, over 200 media posts, and about 100 physical objects, such as signs from protests. About a dozen full-time staff members are working on the project, Mr. Daigle said. The archivists are focusing on preserving third-party materials, such as newspaper articles, because internal communication records already belong to the university, covered under existing record-management policies…

Full story at http://chronicle.com/blogs/wiredcampus/author/achen

via uclafacultyassociation.blogspot.com

This is the future of archivists everywhere. And its going to just get worse. Can you imagine, for example, trying to archive the Arab Spring?

A tribute to Mike Dooley

I have posted A Tribute to MIke Dooley to SSRN. Abstract follows:

A personal and professional tribute to Michael P. Dooley, the William S. Potter Professor of Law Emeritus at the University of Virginia School of Law, upon his retirement in 2012.

Occupy Pennsylvania Avenue: How the Government's Unconstitutional Actions Hurt the 99%

Abstract: Economic freedom is the best tool man has ever had in the perpetual struggle against poverty. It allows every individual to employ their faculties to a multitude of opportunities, and it has fueled the economic growth that has lifted millions out of poverty in the last century alone. Moreover, it provides a path for individuals and communities to free themselves from coercive government policies that serve political elites and discrete political classes at the expense of the politically weak. Because of their relative political weakness, the poor and lower middle class tend to suffer the most from these inescapable power disparities.

Yet economic freedom — and ultimately, economic growth — is not self-sustaining. This tool of prosperity requires sound principles that provide a framework for cooperation and voluntary exchanges in a free society. Principles equally applied to all and beyond the arbitrary discretion of government actors; principles that provide a degree of certainty and predictability in an otherwise uncertain world. That is, economic freedom requires the rule of law, not men.

In this article, we discuss the corrosive effects that unconstitutional actions have on the rule of law, economic growth and, in turn, on the ability of the poor to improve their economic misfortune. We focus on the institutional dangers and adverse incentives that unconstitutional policies tend to create. These dangers are not just abstract or theoretical; this article shows how specific unconstitutional actions adversely affect the lives of poor Americans. And while Part IV shows that even constitutional violations by local governments can have disastrous effects, our central theme is that the federal government’s disregard for the U.S. Constitution has led to policies that kill jobs, stymie economic growth, and ultimately exacerbate the problems of those living in poverty.

via papers.ssrn.com

Shapiro, Ilya and DeNigris, Carl G., Occupy Pennsylvania Avenue: How the Government's Unconstitutional Actions Hurt the 99% (May 7, 2012). Drake Law Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2053595

For Alan Turing’s Birthday: A LEGO Turing Machine

Today is the 100th birthday of the late Alan Turing, famed mathematician and computer scientist responsible for most concepts relating to algorithms and computations. Turing invented the “Turing Machine” an experiment in intelligent machinery which helped to define and enhance computer evolution.

In honor of him and his achievements, the CWI (Centrum Wiskunde & Informatica) in the Netherlands, built this Turing Machine out of LEGOs.

via www.tor.com

Very cool.

Rethinking Jeff Skilling's conviction

After the financial crisis and the recent insider trading convictions of Raj Rajaratnam and Rajat Gupta, perhaps it is time to reconsider the plight of Jeffrey K. Skilling.

... The problem is that the case against the Enron executive was always an iffy one, and in light of recent events, Mr. Skilling’s sentence appears increasingly unjustified.

via dealbook.nytimes.com

District Court holds that California BJR does not extend to officers

Keith Paul Bishop reports that:

In FDIC v. Hawker, 2012 U.S. Dist. LEXIS 79320 (E.D. Cal. June 7, 2012), the FDIC brought suit for $42 million against the former officers of County Bank, a state chartered bank.  The defendants moved to dismiss pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure on the basis that the business judgment rule provided them with immunity from personal liability for acts of ordinary negligence under California law.   U.S. District Court Judge Lawrence J. O’Neill, however, denied the motion.

As an initial matter, Judge O’Neill found that the defendants as officers were not entitled to rely on Corporations Code Section 309:

Defendants seek to blend their conduct as directors with that of officers.  However, as noted by FDIC, the roles of officers and directors are distinct given officers’ performance-based compensation and larger stake in a corporation compared with directors’ limited com-pensation and corporate holdings. Defendants fail to substantiate their claim that “there is no basis under California law to conclude that the business judgment rule’s protections for officers was repealed by implication upon the enactment of Section 309.”

The defendants also claimed that the common law business judgment rule foreclosed the court from second guessing their decisions.  Judge O’Neill, however, found that the business judgment rule is an affirmative defense that involves factual issues that made its application inappropriate to a motion to dismiss.

I am inclined to think that the common law business judgment rule should apply to officers. 

It is reasonably well settled that officers owe a duty of care to the corporation.[1] It is less well settled that officers get the benefit of the business judgment rule. Under the ALI Principles, the rule applies to both directors and officers.[2] Judicial precedents are divided, however.[3] Most of the theoretical justifications for the business judgment rule extend from the boardroom to corporate officers. For detail on those justifications, see  Stephen M. Bainbridge, The Business Judgment Rule as Abstention Doctrine (July 29, 2003). 

Many corporate decisions are made by officers, for example, who are likely to be even more risk averse than directors. Accordingly, insulation from liability may be necessary to encourage optimal levels of risk-taking by officers. Just as the board of directors is properly regarded as a production team, so is the so-called top management team.[4] Accordingly, internal team governance may be preferable to external review. In sum, the better view is that officers are eligible for the protections of the business judgment rule.

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[1] See ALI Principles § 4.01 cmt. a; see, e.g., MBCA § 8.42(a)(2) (requiring that officers exercise the “care that a person in a like position would reasonably exercise under similar circumstances”).

[2] ALI Principles § 4.01.

[3] Compare Galef v. Alexander, 615 F.2d 51, 57 n.13 (2d Cir. 1980) (holding that the business judgment rule “generally applies to decisions of executive officers as well as those of directors”); FDIC v. Stahl, 854 F. Supp. 1565, 1570 n.8 (S.D. Fla. 1994) (holding that the rule “applies equally to both officers and directors”) with Platt v. Richardson, 1989 WL 159584 at *2 (M.D. Pa. 1989) (holding that the rule “applies only to directors of a corporation and not to officers.”). At least one court claims that the former view is the majority position, rejecting an argument that “the business judgment rule applies only to the conduct of corporate directors and not to the conduct of corporate officers” on grounds that it was “clearly contrary to the substantial body of corporate case law which has developed on this issue.” Selcke v. Bove, 629 N.E.2d 747, 750 (Ill. App. 1994).

[4] See Susan G. Cohen and Diane E. Bailey, What Makes Teams Work: Group Effectiveness Research from the Shop Floor to the Executive Suite, 23 J. Mgmt. 239, 265-76 (1997) (describing research on top management teams).

Challenge to key Dodd-Frank financial services provisions

The Competitive Enterprise Institute (CEI) has announced that:

The State National Bank of Big Spring, Texas, today filed a lawsuit asking the U.S. District Court for the District of Columbia to hear its case challenging the constitutionality of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Competitive Enterprise Institute and the 60 Plus Association are also joining this community bank as plaintiffs in the same action, requesting the Court to invalidate the law because of the unprecedented, unchecked power it gives the government. ...

According to the complaint, there are no effective checks and balances to assure the public of accountability.  Most importantly:

• Congress exercises no “power of the purse” over the CFPB, because the agency’s budget – administered essentially by one person – comes from the Federal Reserve, amounting to approximately $400 million that Congress cannot touch or regulate.
• The President cannot carry out his constitutional obligation to “take care that the laws be faithfully executed,” because the President cannot remove the CFPB Director except under limited circumstances.
• Judicial review of the CFPB’s actions is limited, because Dodd-Frank requires the courts to give extra deference to the CFPB’s legal interpretations.
• The plaintiffs claim in their suit that Dodd-Frank gives an agency of unelected government bureaucrats unrestrained power. They argue this unaccountable power over the daily lives of the American people results in a lack of public accountability, creating a power grab over every U.S. citizen.

“As a whole, Dodd-Frank aggregates the power of all three branches of government in one unelected, unsupervised and unaccountable bureaucrat,” said former White House Counsel C. Boyden Gray, attorney for the plaintiffs and founder of Boyden Gray & Associates. ...

The complaint is here. The Federalist Society has put together a web page with links to lots of key documents, including an essay by Boyden Gray that formed the foundation for the law suit. Gray also co-authored a WSJ op-ed on the lawsuit.

These are many of the same guys the guys that won the suit claiming that the PCAOB's lack of accountability to executive branch violated the Constitution. As far as I can tell from a quick glance, their arguments here seem even stronger. The Democrats who wrote Dodd-Frank were determined to insulate these agencies from oversight, presumably out of fear that future GOP Presidents and/or Congresses might actually want to constrain the agencies' powers. But our Constitution doesn't work that way.

Congress defriends Facebook, likely to further foul up IPOs--Part 2

There's a saying that hard cases make bad law. Experience teaches that we need to revise that saying into something like: Newsworthy corporate developments cause Congress to make bad securities laws. The dot-com bubble collapse lead to Sarbanes-Oxley, which aptly has been called quack corporate governance. The financial crisis of 2008 led to Dodd-Frank, which has aptly been called (by yours truly) quack corporate governance round 2. 

Now the Facebook IPO debacle may lead Congress and the SEC to muck about with the securities regulations governing IPOs:

A bipartisan group of lawmakers called on regulators to overhaul the way initial public offerings are conducted, concerned that last month's flubbed stock sale by Facebook shows the current system unfairly punishes small investors. ...

The lawmakers said fundamental changes are needed, even if that means rewriting parts of the landmark Securities Act of 1933, which created the SEC and the existing regulatory framework for overseeing IPOs.

The Facebook deal "taught us that, at a minimum, the IPO process suffers substantial flaws," Mr. Issa wrote in the 15-page letter on behalf of the House committee. The 79-year-old federal law is "fraught with conflicts of interest and incentives to misprice shares."

The US IPO market is in the tank. As I observe in my article, Corporate Governance and U.S. Capital Market Competitiveness:

In the 1990s, the number of foreign issuers listed on the NYSE roughly quadrupled, with NASDAQ experiencing similar growth, while London and the other major European exchanges were losing market share. Since 2000, however, the situation appears to have reversed. Using global IPOs as an indicator of the relative competitiveness of capital markets, for example, there was a dramatic decline in the U.S.’ market share 48% to 8% between 2000 and 2006.

Although the Paulson Committee reported slight improvement in 2008 and 2009, by the first quarter of 2010 the Committee was again reporting continued “deterioration in the competitiveness of U.S. public equity markets.”  As a result, by nearly all measures, the U.S. capital market today remains “much less competitive than it was historically.”

Why did that happen? Back to my article:

There is little evidence that poor corporate governance practices contributed to either the economic turmoil of the last decade in general or the declining competitiveness of U.S. capital markets. ... As far as the economic crisis following the bursting of the housing bubble, “[a] striking aspect of the stock market meltdown of 2008 is that it occurred despite the strengthening of U.S. corporate governance over the past few decades and a reorientation toward the promotion of shareholder value.”  A recent report commissioned by the New York Stock Exchange reached the same conclusion, finding that “the current corporate governance system generally works well.”

If corporate governance was not the problem, what did drive the decline in U.S. capital market competitiveness? According to the Paulson Commission, “one important factor contributing to this trend is the growth of U.S. regulatory compliance costs and liability risks compared other developed and respected market centers.”  This essay therefore focuses on two questions: First, has the risk of anti-fraud liability affected the competitiveness of U.S. capital markets? Second, did the federalization of key aspects of corporate governance during the last decade generate net regulatory costs adversely affecting those markets? 

In short, the answer to both of those question is Yes.

In the article, I demonstrated that the costs created by SOX and Dodd-Frank have substantially distorted corporate financing decisions:

On the one hand, SOX discouraged privately held corporations from going public. Start-up companies opted for “financing from private-equity firms,” rather than using an IPO to raise money from the capital markets. Because “going public is an important venture capital exit strategy, partially closing the exit could impede start-up financing, and therefore make it harder to get ideas off the ground.”  In addition to the decline in domestic IPOs, there was a decrease in new foreign listings on U.S. secondary markets.  The net effect was the declining market share of U.S. markets in such transactions as global IPOs. “Martin Graham, director of the London Stock Exchange’s (LSE’s) market services, said that Sarbanes-Oxley has ‘undoubtedly assisted our efforts’ and emphasized the LSE’s ability to draw new listings from foreign companies.”

Conversely, there has been a trend towards public companies exiting the public capital markets. A Foley & Lardner survey, for example, found that after SOX some 21 percent of responding publicly held corporations were considering going private.  A study by William Carney of 114 companies going private in 2004 found that 44 specifically cited SOX compliance costs as one of the reasons they were doing so. 

In the paper, I demonstrate that there are three major reasons why federal intervention in corporate governance tends to be ill conceived. First, federal securities laws tend to be enacted in a climate of political pressure that does not facilitate careful analysis of costs and benefits.  Second, federal securities laws tend to be driven by populist anti-corporate emotions.  Finally, the content of federal securities laws is often derived from prepackaged proposals advocated by policy entrepreneurs skeptical of corporations and markets.

In sum, the downturn in the US IPO market can be traced in large part to Congressional "reforms" of the last decade.

There is no reason--nada, zilch, none--to think laws enacted in response to the Facebook IPO would be any different. Instead, they likely will just add new burdens and costs to an already over-regulated market that is dying on the vine as it is nibbled to death by regulatory ducks.

Is Venture Capital in Crisis?

The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment and the hindrance of successful exits around the world, but it may have exacerbated the existing problems. Poor returns over the past decade indicate most fund managers do not earn their fees, and investors have been increasingly wary of taking on added risk without getting the reward. Structural changes are inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.

--Cumming, Douglas J. and Johan, Sofia A., Is Venture Capital in Crisis? (June 11, 2012). World Economic Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2082062

via papers.ssrn.com

Congress defriends Facebook, likely to further foul up IPOs--Part 1

The WSJ reports that:

A bipartisan group of lawmakers called on regulators to overhaul the way initial public offerings are conducted, concerned that last month's flubbed stock sale by FacebookInc. FB +0.47% shows the current system unfairly punishes small investors. ...

... the Democratic chairman of a subcommittee of the Senate Banking Committee said regulatory changes are needed to bolster investor confidence sapped by Facebook's botched debut.

"The perception today, and perhaps in too many cases the reality, is that the retail investor comes in at a disadvantage" in IPOs, said Sen. Jack Reed (D., R.I.), in an interview with The Wall Street Journal after the subcommittee held a hearing on this issue.

I'll post in a bit about the merits for further IPO regulation. Right now, however, I want to raise a fundamental question of whether the securities laws ought to continue trying to encourage retail investors in their delusional belief they will ever be anything other than small fry on which the big fish prey.

It makes no sense whatsoever for retail investors to be anything other than entirely passive. 

In The Random Walk Guide To Investing, economist Burton Malkiel explains in layman-accessible terms that no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Even professionally-managed mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time.

What Malkiel wants retail investors to do--and what the economics of investing teach is correct--is to put their money in low-fee, low-expense, passively managed index funds and then walk away. Just walk away and let the power of passive management do the rest.

As the Guardian recently summarized Malkiel's message:

Markets are, broadly speaking, efficient. You can't beat them, so fire your financial adviser and put your money into index funds. These are unburdened by investment management costs, so they will always outperform the average active fund. Build an asset allocation model that suits your age and risk profile, then diligently put money in every month until you retire. Annually rebalance your portfolio – selling what's gone up, and buying what's gone down. And that's about it, really. Oh, and don't forget China.

When Congress and the SEC seek to "protect" the ability of retail investors to invest in things like hot IPO stocks, they are thus doing investors a huge disservice.

Ex Parte Communications And SEC Rulemaking

In this recent post, I discussed a petition submitted by Professor Lucian Bebchuk and nine other academics asking that the Securities and Exchange Commission adopt rules requiring public companies to disclose to shareholders the use of corporate resources for political activities.  The Commission has received over a quarter of a million comments in response to this petition.  In the last three months, Chairman Mary L. Schapiro or members of her staff met privately on three different occasions with supporters of the petition.  Are these ex parte contacts legal?

via CALCORPORATELAW.COM

Like Keith Bishop, I find these secret communications between proponents of shareholder activism and the SEC's top brass very worrisome. And, of course, private ex part communications in this context are more than a bit hypocritical, since the activists claim they're trying to promote transparency.